What’s So Great About ETFs?
The purpose of this article is to help you understand exchange-traded funds (ETFs).
Introduced in the 90s, ETFs are one of the fastest-growing segments of the investment management business. ETFs share many of the same features of mutual funds, yet they also have trading features of common stocks.
Like a mutual fund, an ETF investor owns a proportional interest in pooled assets. And like mutual funds, ETFs are managed for an annual fee. But unlike mutual funds, ETF shares are traded directly on global stock exchanges.
To fully understand ETFs, you’ll benefit from understanding where they came from.
First Came Active Mutual Funds
Historians note that pooled funds first appeared at the start of the 1800s in Europe. The first pooled fund in the United States was the Boston Personal Property Trust in 1893. In 1924, the modern mutual fund was born in Boston with the creation of the Massachusetts Investors’ Trust, which went public in 1928 and still exists today!
Before the stock market crash in 1929, there were a number of mutual funds available, but most were wiped out with the crash. The industry started to grow again after 1940 after two important pieces of American legislation, the Securities Act and the Investment Company Act.
Those first mutual funds were actively managed with individual stocks picked by managers who were trying to get the highest returns possible. Sometimes they were right, sometimes they were wrong - a situation that persists today.
Then Came Indexing
In the 1970s, modern portfolio theory (first introduced by Harry Markowitz in the 50s and built upon by William Sharpe in the 60s) started making people think that we’d be better off “buying the market” than picking individual stocks.
This idea was popularized by Burton Malkiel in 1973 with his book, A Random Walk Down Wall Street.
The first index mutual fund, launched by Vanguard, became available in 1975. Mutual funds like this were initially the only way an investor could participate in an index product.
Bear with me – How Mutual Funds Function
Imagine that a US investor wants $10,000 in S&P 500 exposure through a mutual fund. Regardless of the time of day that investor places an order to buy the mutual fund, the trade is executed only at the end of the trading day at the fund’s ‘net asset value’, NAV.
NAV is calculated once per day for all mutual funds. To determine the NAV, all of the investments in the fund are added together and valued on the basis of closing price for that day. Then, the total portfolio value is divided by the number of shares the fund has issued. The end result is the NAV per share.
That NAV per-share price determines exactly how many shares of the fund $10,000 will buy. If the NAV is $125, the investor will be able to buy 80 shares of the mutual fund.
Suppose the mutual fund manager and the S&P 50 performs exceptionally well and the value of the fund doubles. The investor’s 80 shares are now worth $20,000 ($250 per share).
The investor places an order to sell the shares and at the end of the day the fund company calculates the NAV per share, multiplies that by 80 shares and sends the investor their cash. The next morning, the manager goes into the market to sell enough securities to generate the cash to cover the amount they just sent the investor.
In this way, investors can come and go at any time. New shares are created when new money comes in, old shares are deleted when money goes out, and everyone trades exactly at the NAV.
The challenge is that the pricing is only calculated based on the market values at the end of the day.
And this is the challenge that ETFs address
ETFs trace their roots back to the concept of “program trading,” a computer-based innovation in the 1980s that allowed investors to purchase or sell all the shares of a major index through a single trade.
The first ETF was ‘Toronto Index Participation Shares’, which launched on the Toronto Stock Exchange in 1990. It offered exposure to 35 of the largest companies in Canada, but despite some initial success, this ETF never caught on and was shut down.
S&P 500 SPDR (Spiders)
Many consider the S&P 500 SPDR (pronounced ‘Spider’ and standing for Standard & Poor’s Depositary Receipt) to be the oldest ETF. The ‘ticker’ for this ETF is SPY and it was the first ETF launched in the United States. SPY is the oldest existing ETF in the world.
The ETF industry began to take off in 1996 when Morgan Stanley launched products that provided exposure to a variety of individual country indexes from Morgan Stanley Capital International (MSCI).
Qs
In 1999, one new ETF broadened the popularity of the products wildly. The Bank of New York created an ETF based on the NASDAQ 100 Index and launched it as an ETF called “QQQ” or “Qs”. The response was overwhelming, and Qs attracted billions of dollars in its first year. It became the go-to for investors looking to tactically trade, hedge, or gain exposure to technology stock holdings in one fell-swoop.
Vipers
Meanwhile, Patricia Dunn was getting serious about the ETF business and in 2000 launched more than 50 ETFs under the iShares label. By offering this large number of ETFs, iShares opened up new possibilities: investors could now create portfolios of ETFs, rather than using single products.
Vanguard, the leader in index mutual funds, innovated by devising a legal structure that issued ETFs as a special share class of its existing mutual funds. The Vanguard products, introduced in 2001, were called “VIPERs” (Vanguard Index Participation Equity Receipts).
If there’s one thing the investment industry is consistently good at, it’s creating aggressive and victorious-sounding names and lingo. But I digress.
That’s the basic history of ETFs and how they grew out of the limitations of mutual funds. ETFs continue to grow in popularity with individual investors and are making major inroads with global institutional investors from pension funds to hedge funds.
Bear with me again – How ETFs Function
ETFs, by their very structure, work differently from the way mutual funds work.
ETFs are traded on stock exchanges, but they don’t get on the exchange via an initial public offering. Rather, ETFs rely on a creation/redemption mechanism that allows for the continuous creation and destruction of ETF shares. Understanding how this mechanism works is the key to understanding how they differ from mutual funds.
Imagine, as you did with mutual funds, that you want to put money to work in an ETF. The process is simple: you place an order on the market exchange to buy shares from another investor who wants to sell. The order is executed, and you receive shares of the ETF in your brokerage account just as if you bought shares of a stock.
The ETF firm does not know that you have bought these shares, nor does it receive any inflow of money. Shares simply transfer from one investor to another on the secondary market.
But where do the first ETF shares come from?
The only investors who can create new shares of an ETF are institutional investors called “authorized participants” (APs). The AP creates new shares of an ETF by transacting with the ETF company.
The ETF manager provides a list of securities that it wants to own in the ETF. For instance, an S&P 500 ETF will typically want to own all the securities in the S&P 500 Index in the exact weights they appear in that index. The list of securities is called the “creation basket.” The AP buys the stocks in the creation basket at the specified percentage weightings.
What are the features of ETFs that have made them so successful?
Low Cost
Ask most investors why they own ETFs, and the first answer they will give is: lower cost. The cost savings come from the fact that most ETFs are index funds and, therefore, do not have the costs of discretionary, active portfolio management. Index ETFs tend to be cheaper even than index mutual funds.
Accessible Asset Classes
A second core benefit of ETFs is access. ETFs have created new portfolio construction opportunities by opening up new asset classes for investing. Prior to the growth of ETFs, owning such assets as gold bullion, emerging market bonds, or alternative assets was difficult and costly except for large institutional investors. ETFs have made all areas of the capital markets accessible for any investor with a brokerage account.
Transparency
The traditional asset management industry does not place a high value on transparency, which can harm investors in various ways. Mutual funds are required to disclose their portfolio holdings on a quarterly basis, and they’re allowed a lag of up to 60 days. Hedge funds and institutional fund managers tend to report performance and positions four times a year, a few weeks after quarter-end.
ETF providers, in contrast, tend to share their entire portfolios on a daily basis through their websites. This transparency can be enormously helpful in portfolio construction and analysis.
Most ETFs use relatively clear names based on the indexes they track. For example, iShares Russell 2000 index and Vanguard Total Bond Market index. But some of the most popular mutual funds have uninformative names like Fidelity Magellan, PIMCO Total Return, Growth Fund of America. Although there are, of course, exceptions, clarity is common with ETF names.
Liquidity
The fourth major benefit of ETFs is their liquidity. Being exchange traded, ETFs can be bought or sold on markets at various times throughout the day. Anything you can do with a single stock you can do with an ETF.
Therefore, ETF users are numerous and diverse. Because they trade like equities, ETFs have ‘democratized’ the investment process, providing a marketplace where all types of investors can come together and transact in a transparent manner with full regulatory protection.
But ETFs Require your Attention to What Underlies
ETFs have numerous benefits, but investors should be aware of a number of potential drawbacks before using them in an investment strategy.
Investors new to ETFs and their sometimes-novel asset classes and strategies may be unfamiliar with the underlying assets and associated risks. Even an investor who is well versed in the international equity market may not be familiar with the inherent risks of, say, international corporate bonds or emerging market small-capitalization stocks.
ETFs offering exposure to commodities, inverse returns, or volatility are particularly subject to this caution. Investors considering less conventional investment strategies need to dive deeply into the features of the strategies. Education is the key to understanding the various risks in certain asset classes and strategies and making smart decisions.
And your Attention to Trading Costs Too
Although ETFs have lower expense ratios than mutual funds, some costs must be considered that could differ from those associated with mutual funds. With exchange trade-ability comes the burden of paying commissions. As with trading stocks, these costs are a burden on returns. Recently, a growing number of commission-free trading programs for ETFs have reduced trading costs for certain investors on some trading platforms.
A fundamental shift in the way the financial community operates
Over the past few years, instances of backlash against ETFs and their role in the marketplace have occurred. People have blamed the product for corrupting the price discovery mechanism of the stock market, of posing a systemic risk to finance, and of steering investors into inappropriate and complex investments. In the end, many of these criticisms have not held water. But they do highlight that whenever a new and disruptive technology comes along, significant and in-depth education is needed.
ETFs are powerful tools that lower costs, expand strategic choices, and provide ease of access with transparency. When investors use ETFs appropriately, they can improve their return-risk profiles. Like any powerful tool, however, ETFs can be dangerous if not properly understood.
ETF Strategies for your Portfolio Management
The liquidity, flexibility, and range of ETFs make them useful products. They can serve as core holdings for every asset class, sub-asset class, style, sector, country, or thematic strategy and can support tactical or dynamic strategies, portfolio rebalancing, and risk management. They can be tools for passive or active investing and for top-down or bottom-up portfolio construction.
Bottom Line
In summary, it is fair to say that ETFs have changed the face of investing. With lower fees and greater transparency than traditional mutual funds, ETFs are attracting investors away from mutual funds.
ETFs have also made investing more accessible by providing tools that can be used in asset or sector allocation and thematic investing. They have helped many investors incorporate dynamic strategies in their portfolio management processes by allowing them to adapt to shifting return and risk opportunities.
Broadly, ETFs are encouraging a new approach to investing that focuses on macroeconomic and thematic developments rather than single-stock investing. ETFs encourage investors to consider investing in China or India versus at the level of Royal Bank or Starbucks.
